UPDATE 1-U.S.

High-yield muni buyers lose safeguards

June 22, 2012|Reuters

By Joan Gralla

June 22 (Reuters) - Issuers of U.S. high yield municipalbonds are taking advantage of yield-starved investors, weakeningstandard provisions that shield buyers from the risks that aproject, an issuer or the economy will go sour.

Debt service reserve funds, which are used to repaybondholders if a project doesn't produce enough cash, made thehigh-yield sector of the $3.7 trillion tax-free municipal bondmarket a safer place for retail and institutional investors.

But this safeguard is slowly disappearing. July and Augustcould see this trend accelerate.

Forecasts for net negative issuance - when the supply of newbonds falls below the amount of bonds redeemed or refunded - andrecord demand for relatively safe and profitable investments -are helping these deals find homes - even without thosedefenses. But some major institutional buyers are wary.

"We're getting into the place where it's an issuer's market,the covenants, the types of reserves, the collateral provided,do not make the structures as attractive," as they previouslywere, said Michael Walls, a portfolio manager with the Ivy Fundsin Overland Park, Kansas.

As the U.S. economy slows and Europe struggles to regainfiscal stability, safety-seeking investors have driven Treasuryyields to historic lows. Bolder municipal investors are gainingfatter yields by buying debt issued by struggling issuers, suchas California, and wading into the high-yield sector.

The Barclays high-yield municipal bond index had a totalreturn of 9.61 percent for the year-to-date period ending June21 versus 3.60 percent for the broader municipal bond market.The Treasury index only returned 1.69 percent. All maturities inthe indexes are longer than one year.

A prominent example of an issue becoming more risky is the$774 million of prepaid gas bonds that Goldman Sachs isunderwriting for Alabama's Black Belt Energy Gas District. Thedeal was postponed last week; a Goldman spokesman had noimmediate comment on when the sale might be rescheduled butthere is market speculation it will be soon.

Prepaid gas bonds provide local utilities with a steadysupply of natural gas at a pre-determined price, protecting themfrom volatile energy prices. The banks that underwrite andstructure the deals gain access to funds at tax-free yields,while their commodities units provide the gas supply.

Until recently, a credit rating downgrade below investmentgrade for the bank standing behind the deal typically requiredit to deliver hundreds of millions of dollars in cash, cashequivalents or a letter of credit.

But the new Black Belt Energy bonds - along with the onlyprepaid gas bond issued so far in 2012 -- a $613 million issueby the Central Plains Energy Project, which also wasunderwritten by Goldman - have no credit rating trigger.

On June 21, Goldman Sachs was downgraded two notches to A3from A1 - still comfortably in the investment grade zone - byMoody's Investors Service..

On Friday, the vulnerabilities of the prepaid gas bondsector were highlighted when Moody's Investors Service cutratings on 24 issues worth about $19 billion. The downgradeswere a knock-on effect from the credit agency's cutting theratings of 15 banks on Thursday..

JULY AND AUGUST, TWO MONTHS AT RISK

"The change that I have seen in the transactions, generally,as of late, especially in the Central Plains and Black Beltdeals, is that a lot of risk is now being backstopped by the gassupplier or the investment bank, in a secondary capacity throughstructures like a receivable purchase agreement or a custodialagreement," said Bhala Mehendale, a director at Fitch Ratings.

Last January, investors in a $1.8 billion deal issued by theTennessee Energy Acquisition Corp in 2006 voted in favor of aproposal from Goldman to scrap the credit rating trigger.

Lower-rated nonprofit hospital bonds are other examples ofdeals that are offering investors fewer protections. A $60million sale by the Maryland Health and Higher EducationFacilities Authority, Carroll Hospital Center Issue, on May 2had no debt service reserve fund, according to offeringdocuments.

Those reserve funds, an important safety feature to someinvestors, were common when demand for high-yield municipalbonds was lower.

James LeBuhn, a Fitch Ratings analyst, said there has beena shift from the first half of 2011, when municipal investorswere still rattled by Wall Street analyst Meredith Whitney'sprediction that local governments would default on hundreds ofbillions of debt. The subsequent rebound in demand has allowedissuers to weaken protections previously seen in bondcovenants.

On Thursday, a $182 million offering by the PhoenixIndustrial Development Authority for Rowan University had nodebt service reserve fund, according to the preliminarydocuments.

A $46 million sale by Florida's Higher Education FacilitiesRevenue and Refunding Bonds, a Nova Southeastern Universityproject, in April also lacked the protections that investorsused to demand, Walls said.

July and August might be a particularly vulnerable time forinvestors because that is when a net negative supply is expectedto develop.